Negotiation Beats Eminent Domain for Underwater Mortgages

From a casual reading of real estate news, one might conclude that the U.S. housing bust is over. Nationally, home prices have risen for 16 months straight, and are about where they were in 2004.

But for 9.7 million homeowners, happy times aren’t here again. Those are the wretched borrowers, almost 20 percent of households with a mortgage. who owe more than their homes are worth. Their negative equity totals $580 billion.

That sum is suddenly the object of a battle royale. On one side are the biggest U.S. banks, the bond market and the real estate industry. On the other are those underwater homeowners, a couple-dozen communities where they mostly reside and a San Francisco venture-capital firm, Mortgage Resolution Partners LLC, proposing what it claims is the ideal fix, in three easy steps.

Step one: Cities invoke eminent domain to seize underwater mortgages embedded in investor-owned bonds. Step two: Using private money, cities pay off the investors on those loans at a discount on their face value. Step three: The mortgages are refinanced with smaller loans, turning the negative into positive.

All this is the brainchild of Cornell law school professor Robert Hockett, who outlined the plan in a Federal Reserve Bank of New York paper. His logic is sound enough: Negative-equity households would be discouraged from defaulting; banks and bondholders would save money in the long run by avoiding foreclosures and short sales. Housing dead zones such as Richmond, California, a blighted, blue-collar city of about 106,000 on the east side of San Francisco Bay, and the epicenter of this fight, might even spring back.

Trapped Homeowners

Richmond wants to be the first to use eminent domain this way. Many of its residents are out of work, the unemployment rate is above 11 percent, and trapped. They can’t take jobs elsewhere because they can’t sell their homes or refinance at today’s low rates. As of May, 2,759 owners had negative equity, according to CoreLogic Inc.

But eminent domain is a powerful tool, and should be used sparingly. It wouldn’t serve the U.S. well if this gambit frightened off the steady stream of investors needed to purchase the mortgage securities that allow homebuyers to borrow at attractive rates.

Perhaps more important, Fannie Mae and Freddie Mac are threatening to stop doing business in cities that resort to eminent domain. Without buy-in from the two government- controlled home-loan financiers, which hold about 10 percent of private-label mortgage securities (the type at stake here) and whose guarantees the new mortgages would need, the idea may be doomed.

Even more practically, the interests that oppose eminent domain will surely fight all the way to the Supreme Court, stranding Richmond’s homeowners for several more years. This week, mortgage-backed-bond trustees, including Pacific Investment Management Co. and BlackRock Inc., asked a federal district court to block the city from even attempting the ploy.

This isn’t to say we accept the argument that seizing mortgages would be unconstitutional. Governments have used eminent domain to clear the way for roads and other public-works projects that serve the public interest. The Supreme Court in 2005 expanded its use, allowing cities to condemn private property on behalf of commercial developers for projects such as hotels and office buildings along a neglected waterfront. Why wouldn’t that reasoning apply to a city wishing to rehabilitate its housing stock?

Nor do we accept that seizing mortgages would necessarily harm the pension funds, college saving plans and workers’ 401(k) retirement accounts that hold mortgage bonds. Even though eminent domain would be used mostly in cases where homeowners are current on payments, the likelihood of default is high on any underwater loan. This is especially true now that interest rates are rising on adjustable loans, which most underwater mortgages are.

Recovery Chances

Banks and bond funds are disingenuous when they say they are acting to protect investors, when investors would be better off in the long run if default incentives were reduced. The typical recovery value after a default on loans such as those in Richmond has been less than half of the principal balance.

One reason for banks’ reluctance to modify mortgages is that they collect fees as loan servicers. The banks also receive revenue on second mortgages from many of the same homeowners. If eminent domain worked, and other cities followed suit, the $580 billion negative-equity pot would shrink, along with both sources of revenue. Some banks would also have to declare losses on the second loans if forced to sell them at a discount.

It strikes us that the ideal middle path would be to adapt the refinancing concept Richmond has in mind, without actually seizing loans through eminent domain. If banks and asset managers aren’t willing to modify loans, and there is value to be unlocked by doing so, then they have a financial obligation to negotiate. If the two sides can’t agree on a fair value, then eminent domain wouldn’t work, either.

The disposal of toxic mortgages will always be about negotiating a price that works for both sides of the transaction. Isn’t that what Wall Street does every day?